Comstock Partners, Inc.February 28, 2017
THE STOCK MARKET IS PRICED FOR PERFECTION
But Politics, Debt, and Stagflation May Change Things
The Trump rally, which began during the overnight session the night of November 8th has, in our view, built perfection into prices, which we think were already priced to near perfection. In the bull case, fundamentals were already improving and President Trump’s proposed cutting of regulations, taxes, and instituting pro-growth fiscal spending, just adds fuel to the fire. It seems to us that every possible benefit of the doubt is being given to the new administration in an economic and political climate that is unprecedented in our lifetime, and possibly our country’s history.
In addition, there is nothing that says that President Trump will get all he wants from Congress. The most positive outcome is being discounted by the stock market presently and if there is resistance or delay with his programs, the stock market will suffer. The U.S. will need to raise the debt ceiling in mid-March, and we do not believe the market has focused on that. With debt and interest rate exposure that are enormous, we do not believe that Republican deficit hawks, that have spent their careers as such, will be so eager to approve spending increases that are not offset by spending cuts. Additionally, we expect Democratic opposition to the President’s agenda to be fierce. So the Trump programs which have been treated by the market as a forgone conclusion will, in our view, be much more difficult.
The Fed continues to state that three rate increases are on the table for 2017. Our view of the matter is that the Fed is walking a tightrope as the $20tn. of US debt is relatively short in duration, with a maturity of just over 5 years, and just under a 2% average coupon. Thus, there is enormous interest rate exposure in terms of the debt and deficit, for that reason alone, it is likely the Fed will be behind the curve. The exposure created by the $20tn. of debt (and possibly much more debt under President Trump), along with $100tn. in unfunded liabilities and entitlements, puts the US and the Fed in a very serious bind as each 1% increase in funding cost to the government will add $200bn. to the national debt. Additionally, as labor markets tighten (with corresponding negative effects on profit margins), the Fed moving gingerly risks an acceleration in inflation.
As our readers know, we are believers that high debt is, in and of itself, a dampening factor on economic growth. We have also written many times about how the 8 years of close to zero interest rates has caused risk assets to be mispriced. The European Central Bank (ECB) and Bank of Japan (BOJ) mimicked us, and even upped the ante with negative rates. And the BOJ purchases of equities, has further inflated the bubble in Japan. The newest economic superpower, China, is in a credit bubble of its own that is even larger than ours as a percentage of its economy. While President Trump has referred to China as a currency manipulator, they are doing exactly the opposite. A weak currency will only exacerbate an already serious capital flight problem. Therefore, they have been trying to strengthen the Yuan.
There is an argument being made currently by Alan Greenspan, that we are headed from “Stagnation to Stagflation”. In the beginning of this cycle, profit margins and the stock market should move up as inflation gains momentum. But it will not continue because what is really going on longer term is a problem with the productivity of the economy. As our country ages and retires, we will not have an influx of baby boomers entering the workforce like we had in the 1980’s and 1990’s. These population demographics cause a problem with growth in entitlements. The entitlements crowd out savings which results in less investment in productive assets. We subscribe to this argument and strongly believe this to be a headwind to growth that will exist unless we get many more workers entering the labor force. More working immigrants entering the country would ease the situation, but would bring its own additional set of problems.
On the subject of valuation, our favorite measure is the trailing twelve month Generally Accepted Accounting Principles (GAAP) P/E of the S&P 500. With 92% of S&P companies reporting (as of 2/24/17) it appears the trailing twelve month GAAP earnings are just under $96. That’s a current P/E of 24.7. We don’t believe that a 2% growth environment justifies that valuation. Furthermore, analyst’s estimates compiled by S&P, project that earnings growth in the next two years will be just under 17% a year. This is in an economy which has not been able to get above 2% annual growth and stay there. Even if earnings did grow at that rate, the GAAP P/E in 2 years (at this level of the market) would still be around 18, which is historically expensive. If the economy and earnings are growing at that rate, one would have to think that interest rates and inflation will rise. And if GAAP earnings are capitalized at significantly higher interest rates, it will naturally be a problem for stocks.
In summary, it is our view that the market is in the third credit driven bubble of this century. We believe that the strong move since the election has more to do with hopes and dreams of what could happen rather than the reality of what is likely to happen. The additional growth that could come as a result of less regulation and lower taxes pales beside the inflation in asset values, especially stocks, due to the policies of the Fed. In that sense, it doesn’t actually matter all that much who the president is. Debt and demographics are working against us and it will take, in our view, a bear market of epic proportions to correct the excesses in valuation that exist.